The latest US inflation data has been met with optimism from markets, but is this enthusiasm premature?
- US inflation fell more than expected, dropping to 4.9%
- There remains a clear gap between the market’s view and the Fed’s view
- The arguments on both sides are finely balanced
US inflation continued to slow in April, falling through the symbolic 5% mark to 4.9%. This was lower than expectations and the tenth month where the rate of price increases has declined. Markets responded positively to another sign that this period of worrying inflation may be drawing to a close.
There remains a discernible gap between the market’s view and the Fed’s view. While markets believe that this gives the Federal Reserve all it needs to halt rate rises, Fed President John Williams warned that the central bank was not done raising rates.
He said: “I see a need to keep a restrictive stance of policy in place for quite some time to make sure we really bring inflation down from 4% all the way to 2%. I do not see in my baseline forecast any reason to cut interest rates this year".
There is plenty to support the view that rates should remain higher. Core inflation, for example, is proving sticky. At 5.5%, it was down just 0.1% on the previous month. Inflation remains significantly higher than the 2.1% average reported from 2000 to 2020. The latest jobs report was ‘hot’, with payroll employment, the unemployment rate and hourly earnings all coming in stronger than expected.
On the other hand, the Fed minutes from the previous meeting showed some signs that the central bank was softening its stance. Committee members had lowered their expectations for rate hikes, and were alert to any weakening in credit conditions in response to the banking sector turmoil. It also showed that the Committee is forecasting a mild recession later this year, which may also prompt a change of thinking on rates.
It may seem ridiculous to say, given how long markets have been watching the Fed’s every move, but it’s probably still too early to tell. Interest rates operate with a lag and while they seem to be having an effect, continued falls in inflation cannot be taken for granted. If inflation continues to drop over the next few months, it may suggest that the level of interest rates is high enough, but it is not a done deal yet.
All that can be said about the most recent round of data is that it makes a Federal Reserve pause fractionally more likely. Markets may interpret it more optimistically, but their view is probably already too positive. It may work out OK, but there are plenty of risks on the other side.
